Barrick Gold: The Ultimate Window Into a Misunderstood Industry

Gold clearly means very different things to different people. Some have embraced gold exposure to defend against the devaluation of competing currencies, while others cling to a dogged dismissal of the metal's relevance and value. Depending on which window they peer through when examining gold, it seems one can draw all manner of conclusions to suit a given financial worldview.

As the investment world stomps its way through the never-ending debate over the nature of gold and its long-term price outlook, the miners continue to go about their business of extracting the stuff from the ground in return for enormous profits. The largest gold miner of them all -- Barrick Gold (NYS: ABX) -- saw its adjusted second-quarter income climb 36% over the prior-year mark to reach $1.1 billion. The miner's cash margin surged 33% to $1,068 for each of the 1.9 million ounces sold, while remarkable pricing strength from byproducts like silver allowed Barrick to lower full-year guidance for net costs all the way from a range of $340 to $380 per ounce, to a revised target of between $290 and $320 per ounce.

Despite that powerful performance, the scale and geographical scope of Barrick's wordwide operations offers investors the clearest possible window into a trend of rapidly accumulating cost pressures facing the gold-mining industry at large. In other words, even Fools who have opted for gold exposure through my top picks like Brigus Gold (ASE: BRD) or AuRico Gold (NYS: AUQ) are encouraged to pay close attention to major producers like Barrick for insight into these important industry dynamics. As the preeminent golden goliath, Barrick Gold offers the ultimate window into these trends as they unfold.

Mine construction sticker shock
We'll save an in-depth look at the factors pressuring operating costs for another time and focus instead today on the significant uptick in the capital costs for mine construction and development.

Fools may recall that Kinross Gold (NYS: KGC) balked at the rising price tag for the Cerro Casale project in Chile, selling a further 25% interest in the project to Barrick last year, when the construction budget rose to $4.2 billion. But Barrick last week conceded that the project will probably cost $6 billion before its 23.2 million ounces of gold can begin to be tapped. Corrobortating this inflationary trend, NovaGold Resources (ASE: NG) recently indicated that its price tag for the storied Galore Creek joint venture now stands at $5.2 billion (or 373% more than the companies envisioned back in 2006).

Less than two years ago, Barrick expected to incur capital costs of $2.8 billion to construct its world-class Pascua Lama gold mine on the border between Chile and Argentina. Even just a couple of months ago, the anticipated tally stood at $3.3 billion to $3.6 billion. In its second-quarter earnings release, however, Barrick revealed another major increase to between $4.7 billion and $5 billion. As a poignant aside, the change underscores part of the genius inherent in Silver Wheaton's (NYS: SLW) unique business model, since the silver stream holder is 100% isolated from Barrick's rising cost structure for Pascua Lama.

Barrick identified the major culprits in the trend as "continued inflationary effects on costs for key consumable inputs and labor," including "re-estimations of materials such as steel, cement, fuel, and equipment." Noting that these increasing costs are also accompanying increasing projected rewards, Barrick explained: "The mining industry is facing global cost trends which reflect a substantially higher commodity price environment, stronger local currencies, tighter labor markets and higher inflation in some regions compared to several years ago, when many projects were at the feasibility stage. For Barrick, stronger metal prices have significantly improved project economics and overall rates of return despite higher estimated capital costs."

Under the circumstances, the last thing Barrick needed was a weather-related disruption at another major gold-development project. But when the rains fell in the Domincan Republic last May, Barrick was forced to add another $1 billion to the budget for the Pueblo Viejo joint venture with Goldcorp (NYS: GG) ; while pushing back the mine's scheduled startup to mid-2012.

What the rising cost of gold production means for Fools
While presenting a potential sharp thorn in the side of companies possessing projects with only marginal economics at prevailing gold prices, these inflationary forces are likely to bolster the performance of gold-mining shares and fuel the fire of gold's longstanding price momentum.

Over the long term, the average total ("all-in") industrywide cost of extracting an ounce of gold from the ground acts like a cement floor beneath gold prices that combines with underlying demand dynamics to exert upward pressure on gold prices as the cost structure rises. When gold prices collapsed back in 2008, I used Barrick Gold's estimation of an industrywide breakeven price of $700 to $800 to target the range where gold investors could safely make their stand to position for the next upward leg. Judging by the scale of Barrick's capital-spending revisions since that timeframe, it's clear that the cement floor beneath long-term gold prices has been rising steadily alongside the prices for gold and common byproduct metals such as silver and copper. Unfortunately for Fools, all-in cost metrics are closely guarded by mining companies, with Gold Fields the lone gold miner I'm aware of that routinely divulges its own breakeven benchmark.

Meanwhile, rising capital costs increase the likelihood that marginal projects will be shelved and raise the barrier to entry for junior or non-producing development companies struggling to find financing for a new mine. In other words, these cost pressures are bound to constrain global gold supply, combining with persistently bullish demand dynamics to exert substantial upward pressure on gold prices over time. Unless the trend Barrick bears witness to reverses course dramatically, I believe the supply-side impact will offer a further impetus for gold prices above $2,000 per ounce that few doubting onlookers are likely to have properly considered.

Finally, I wish to point out that the cost pressures Barrick referenced are visible throughout the metals-mining complex, similarly affecting the markets for silver, copper, lead, and zinc. Those metals present bullish, price-inelastic, demand-driven outlooks of their own, which similarly combine with the bullish supply-side scenario resulting from rising costs. I believe rising byproduct revenues will continue to defend the feasibility of quality gold-mining projects against the onslaught of higher capital expenditures, much to the delight of investors who select the best-positioned miners in the industry.

At the time this article was published Fool contributor Christopher Barker can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He tweets, and he owns shares of AuRico Gold, Brigus Gold, Silver Wheaton, and Teck Resources. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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